Draining IRAs too soon poses big risks

Don’t touch that IRA, but if you do...

Americans between the ages of 61 and 70 are withdrawing money from their IRAs in amounts that are larger, both in absolute dollar amounts and as a percentage of their IRA account balance, than those taken by older households, according to a new report from the Employee Benefit Research Institute.

And what’s especially troubling about that finding is this: IRA owners under the age of 70½ are not even legally required to start taking required minimum distributions (RMDs) from their IRAs. Under current tax rules, traditional IRA account holders are only required to start taking withdrawals from their IRAs no later than April 1 of the year following the year in which they reach age 70½.

According to the EBRI report, Americans between the ages of 61 and 70—the so-called pre-RMD crowd—withdrew on average $16,655 per year from their IRAs, while those between the ages of 71 and 80 withdrew $10,557. What’s more, the pre-RMD Americans spent most of their IRA withdrawals on regular expenses, while the post-RMD set actually saved some of their withdrawal in CDs and the like.

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The numbers are even worse for pre-RMD Americans who are in the two lowest-income quartiles. Nearly half of those households withdrew money from their IRAs, and on average those in the lowest-income quartile withdrew 17.4% of their account balance. That amount, by the way, exceeds the percentages required to be taken by those withdrawing RMDs, which start at around 3.75% for most IRA owners and don’t exceed 6% until about 83, said Jeffrey Levine, an IRA Technical Consultant with Ed Slott and Co. and a contributor to MarketWatch’s RetireMentors.

Now this might not come as a surprise, but the consequences of dipping into one’s IRA before age 70½ are significant. People could be putting their future standard of living at risk, especially if they don’t other sources of income in retirement such as a defined benefit pension plan or income from employment.

“I think we are seeing for the age group of 61 to 70, people who had planned to continue working but due to layoffs, a bad economy, and the like now need to dip into their retirement dollars far sooner than expected or planned,” said Thomas O’Connell, president of Senior Wealth Solutions. “With the likelihood of a 20- to 40-year retirement time frame, this is going to be catastrophic for many of these folks in their later years.”

You don’t have to search far to find others who share that outlook. “I’m not surprised by this,” said Jeremy Portnoff of Portnoff Financial. “Many reports show that people do not save enough so it makes sense that when they get to retirement—some are retiring too early, they have not accumulated enough money—their distributions are much larger than they would be required to be. This probably doesn’t bode well for their ability to sustain relatively high withdrawals.”

Others see the same problem, but a different cause. “I think what is happening is many corporations have moved away from monthly pensions for retirees, thus leaving the money management decisions and the withdrawal rate decisions up to the consumer,” said Matt Curfman, a senior vice president with Richmond Brothers.

Often, he said, a younger retiree, defined as someone in their mid-50s to mid-60s, will want to draw more out while they are young and healthy, but they do so at a great risk. “Should they live well into their 80s or 90s, it is entirely possible that they may run out of money if they kept that higher withdrawal rate up over longer periods of time,” said Curfman.

In many cases the higher withdrawal rate at a younger age can be OK as long as when another source of income comes in, such as Social Security payments, that withdrawal rate is reduced accordingly, Curfman said.

Absent that, Curfman said the only way a high withdrawal rate will work is if the rate of return on a portfolio always exceeds that withdrawal rate. He noted, for example, that from 2000 to the end of 2012 the S&P 500 average return was 3.45% per year and the actual return was 1.61% per year. “If you were retired for this 13-year period with your portfolio invested in the stock market and your withdrawal rate exceeded 1.61% it is very likely that your portfolio has lost money or is down from where you started. That can be unsettling, especially if these were the early years of your retirement.”

Meanwhile, the author of the EBRI report said IRA owners must be neither overly cautious nor overly aggressive when it comes to IRA withdrawals. “As more and more baby boomers enter retirement with large portions of their retirement savings in IRAs, their financial security in retirement may well depend on how they manage these accounts postretirement,” Sudipto Banerjee, EBRI research associate and author of the report, said in a release. “Some may be overly cautious in drawing down their IRA balances, sacrificing a more enjoyable retirement, while others may spend too much too soon, jeopardizing their retirement security.” Read IRA Withdrawals: How Much, When, and Other Saving Behavior.

Exceptions to the rule

In the main, experts advise against withdrawing money from your IRA to pay for current living expenses. “There’s a reason many people with large IRA balances or other savings hold off on taking distributions for as long as possible,” said Levine. “If you can afford to wait, it generally produces better results.”

But there are exceptions to the rule. In fact some experts recommend that Americans withdraw money from their IRAs before age 70½ and delay taking Social Security until age 70. Doing so, the experts say, reduces the amount of one’s RMDs and taxable income and it also increases the amount of one’s Social Security benefit. Read Innovative Strategies to Help Maximize Social Security Benefits. Read also The Baby Boomer’s Guide to Social Security.

“When I talk to my clients about retirement-income planning we are talking about several things that are not intuitive to them,” said Craig Adamson, president of Adamson Financial Planning. “First, when should they draw on their Social Security? Sometimes it makes sense to pull money from IRAs in a low-tax environment and let the Social Security income continue to grow to full retirement age or up to age 70 to maximize the benefit.”

Of course, when taking early distribution keep a close eye on your tax bracket: “By taking early distributions from IRAs, are they going to break through into the next tax bracket to support their lifestyle?” asked Adamson. “Is this money they could be taken from Roth IRAs, non-qualified accounts such as bank savings or CDs, or from cash value life insurance so there is no tax consequence.”

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